The Risk Illusion

As emotional beings, we are susceptible to illusions and phobias. Never mind that the snake under the bed turned out to be a sock, or that the monster in the closet was a hat and overcoat. At times our irrational fears seem so real that no amount of reason can calm us. At the same time, there are real perils that we tend to ignore.

What is more frightening when swimming in the ocean: a heart attack, or a shark attack? The heart attack is 1000 times more common, but you are thinking about that Great White shark aren’t you? (Queue “Jaws” music: dun dun dun dun dun dun….!!!)

To investors, the shark attack is market risk, with the same visceral pit in the stomach, as you look at your account statement and see that your investments have dropped in value. During the last two bear markets, some aggressive investors lost over 50% of the value of their investments.

While the shark attack/market risk is a real risk, it is NOT the one we should focus on. After all, anyone who has avoided panic and simply held a diversified equity portfolio during a bear market has always fully recovered, and then some. Rather, what we should be more concerned about is the more common and dangerous heart attack, and for investors that is withdrawal risk: The risk that by drawing down your assets too aggressively to pay for excessive spending, you will completely deplete your assets before you die.

Caution: Investors who are overly fearful of market risk are more likely to become a victim of withdrawal risk! Imagine swimming in the ocean and you are SO afraid of the potential shark attack that you give yourself a heart attack. Fearful investors eliminate market risk by selling their equities and placing their assets into bonds and cash. This lowers expected returns, which in turn may reduce your chances of accomplishing your retirement goals.

The moral of the story is to accept some level of market risk (go ahead and swim in the ocean; shark attacks are rare) and by so doing lower the more dangerous withdrawal risk (calm down and don’t give yourself a heart attack.)